Chapter 12. The Design of the Tax System Introduction One of the Ten Principles from Chapter 1: A government can sometimes improve market outcomes. providing public goods regulating use of common resources remedying the effects of externalities To perform its many functions, the govt raises revenue through taxation. slide 0 slide 1 Introduction Lessons about taxes from earlier chapters: A tax on a good reduces the market quantity of that good. The burden of a tax is shared between buyers and sellers depending on the price elasticities of demand and supply. A tax causes a deadweight loss. In this chapter, look for the answers to these questions: What are the efficiency costs of taxes? How can we evaluate the equity of a tax system? slide 2 slide 3
In this world nothing is certain but death and taxes.... Benjamin Franklin In this world nothing is certain but death and taxes.... Benjamin Franklin 100 80 60 40 20 0 1789 Taxes paid in Ben Franklin s time accounted for 5 percent of the average American s income. 100 80 60 40 20 0 1789 Today Today, taxes account for up to a third of the average American s income. slide 4 slide 5 Percent of Revenue as GDP 35 Figure 1 Government Revenue as a Percentage of GDP Table 1: Central Government Tax Revenue as a Percentage of GDP 30 Total government 25 State and local 20 15 Federal 10 5 0 1902 1913 1922 19271932 1940 1950 1960 1970 1980 1990 2000 Source: World Development Report 1998/99 slide 6 slide 7
Receipts of the Federal Government 2004 Table 3 Federal Income Tax Rates: 2004 Individual Income Tax, 43% Social Insurance Tax, 39% Corporate Tax, 10% Other, 8% slide 8 slide 9 Federal Government Spending: 2004 The Demographic and Fiscal Challenge Net Interest, 7% Other, 15% Social Security, 22% Defense, 20% Medicare, 12% Income Security, 15% Health, 10% slide 10 slide 11
The Demographic and Fiscal Challenge Government Budget budget surplus: an excess of government receipts over government spending. budget deficit: an excess of government spending over government receipts. slide 12 slide 13 Taxes and Efficiency One tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers. The costs to taxpayers include: the tax payment itself deadweight losses administrative burden Taxes and Efficiency Well-designed tax policies minimize the deadweight losses that occur when taxes distort incentives. They also minimize the administrative burdens that taxpayers face when complying with tax laws. slide 14 slide 15
Deadweight Losses Deadweight Losses One of the Ten Principles: People respond to incentives. Recall from Chapter 8: Taxes distort incentives, cause people to allocate resources according to tax incentives rather than true costs and benefits. Joe Jane Values $8 $6 No tax ( P=$5) Buy CS=$3 Buy CS=$1 After taxation (P=$5+$2 =$7) Buy CS=$1 Not buy The result: a deadweight loss. The fall in taxpayers well-being exceeds the revenue the govt collects. Govt Revenue Tota CS 0 $4 $2 $1 slide 16 slide 17 Income vs. Consumption Tax Income vs. Consumption Tax Interest rate 8% 8% Tax on interest 0 25% Tax on Consump tion 25% 0% 2007 $100 $100 2047 $2172 $1029 After all taxes $1629 $1029 The income tax reduces the incentive to save: If income tax rate = 25%, 8% interest rate = 6% after-tax interest rate The lost income compounds over time. Some economists advocate taxing consumption instead of income. would restore incentive to save better for individuals retirement income security and long-run economic growth slide 18 slide 19
Income vs. Consumption Tax Consumption tax-like provisions in the U.S. tax code include Individual Retirement Accounts, 401(k) plans. People can put a limited amount of saving into such accounts. The funds are not taxed until withdrawn at retirement. Europe s Value-Added Tax (VAT) is like a consumption tax. Administrative Burden includes the time and money people spend to comply with tax laws encourages the expenditure of resources on legal tax avoidance e.g., hiring accountants to exploit loopholes to reduce one s tax burden is a type of deadweight loss could be reduced if the tax code were simplified but would require removing loopholes, politically difficult slide 20 slide 21 Marginal vs. Average Tax Rates average tax rate total taxes paid divided by total income measures the sacrifice a taxpayer makes marginal tax rate the extra taxes paid on an additional dollar of income measures the incentive effects of taxes on work effort, saving, etc. how much the tax system discourages people from working. Case Study: Iceland s s Natural Experiment Until 1987, individuals in Iceland paid taxes based on their income in the previous year. Beginning in 1988, however, taxes began to be based on current income. Total hours worked rose in 1987 by 3 percent and fell back to its normal level in 1988. Real GDP was 4 percent higher in 1987 slide 22 slide 23
A lump-sum tax is the same for every person Example: lump-sum tax = $4000/person income $20,000 $40,000 Lump-Sum Taxes average tax rate 20% 10% marginal tax rate 0% 0% Lump-Sum Taxes A lump-sum tax is the most efficient tax: causes no deadweight loss does not distort incentives, as a person s decisions have no tax consequences minimal administrative burden no need to hire accountants, keep track of receipts, etc. Yet, not used because perceived as unfair: in dollar terms, the poor pay as much as the rich relative to income, the poor pay much more than the rich slide 24 slide 25 In the News: How Taxes Affect Married Women When working women marry, they often find themselves pushed into higher tax brackets. Higher income bracket will affect women s (secondary earner) decision to work How much? Experiment : Act of 1986 : slashed the top marginal tax rate from 50% to 28% 99th percentile of family (top 1%): women working rose (46 to 55%: 19% increase) Those who already work increase hours by 13% 75th percentile family: a smaller tax cut 7% increase, 9% increase Taxes and Equity Another goal of tax policy: equity distributing the burden of taxes fairly. Agreeing on what is fair is much harder than agreeing on what is efficient. Yet, there are several principles people apply to evaluate the equity of a tax system. slide 26 slide 27
The Benefits Principle Benefits principle: the idea that people should pay taxes based on the benefits they receive from govt services Tries to make public goods similar to private goods the more you use, the more you pay. Ex) Gasoline taxes the more you drive on public roads, the more gas you buy, so the more gas tax you pay Ex) wealthy must pay more than poors. Why? The Ability-To To-Pay Principle Ability-to-pay principle: the idea that taxes should be levied on a person according to how well that person can shoulder the burden suggests that all taxpayers should make an equal sacrifice to support govt recognizes that the magnitude of the sacrifice depends not just on the tax payment, but on the person s income and other circumstances a $10,000 tax bill is a bigger sacrifice for a poor person than a rich person slide 28 slide 29 Vertical Equity Vertical equity: the idea that taxpayers with a greater ability to pay taxes should pay larger amounts For example, people with higher incomes should pay more than people with lower incomes. Three Tax Systems Proportional tax: taxpayers pay the same fraction of income, regardless of income Regressive tax: high-income taxpayers pay a smaller fraction of their income than lowincome taxpayers Progressive tax: high-income taxpayers pay a larger fraction of their income than lowincome taxpayers slide 30 slide 31
Table 7 Three Tax Systems Table 8 The Burden of Federal Taxes Source: Congressional Budget Office. Figures are estimates for 2005. Dollar figures are expressed in 2001 dollars. slide 32 slide 33 Horizontal Equity Horizontal equity: the idea that taxpayers with similar abilities to pay taxes should pay the same amount Problem: Difficult to agree on what factors, besides income, determine ability to pay. Horizontal Equity Similar should pay the same amount What is similar? families differ in many ways. need to determine which differences affect ability to pay. Smith and Jones $50,000 Smith: no children, illness (medical expense of $20,000) Jones: four children ($30,000 in tuition), no health problem slide 34 slide 35
1A: A C T I V E L E A R N I N G 1A Taxes and Marriage The income tax rate is 25%. The first $20,000 of income is excluded from taxation. Tax law treats a married couple as a single taxpayer. Sam and Diane each earn $50,000. i. If Sam and Diane are living together unmarried, what is their combined tax bill? ii. If Sam and Diane are married, what is their tax bill? 1A: A C T I V E L E A R N I N G 1A Answers If unmarried, Sam and Diane each pay 0.25 x ($50,000 20,000) = $7500 Total taxes = $15,000 = 15% of their joint income. If married, they pay 0.25 x ($50,000 20,000) = $20,000 or 20% of their joint income. The $5000 increase in the tax bill is called the marriage tax or marriage penalty. 36 37 1B: A C T I V E L E A R N I N G 1B Taxes and Marriage The income tax rate is 25%. For singles, the first $20,000 of income is excluded from taxation. For married couples, the exclusion is $40,000. Harry earns $0. Sally earns $100,000. i. If Harry and Sally are living together unmarried, what is their combined tax bill? ii. If Harry and Sally are married, what is their tax bill? 38 1B: A C T I V E L E A R N I N G 1B Answers If unmarried, Harry pays $0 in taxes. Sally pays 0.25 x ($100,000 20,000) = $20,000 Total taxes = $20,000 = 20% of their joint income. If married, they pay 0.25 x ($100,000 40,000) = $15,000 or 15% of their joint income. The $5000 decrease in the tax bill is called the marriage subsidy. 39
Marriage Taxes and Subsidies Sam Sally John Joan Result Income $0 $100,000 $50,000 $50,000 Before marriage $0 $20,000 (80,000*25%) $7,500 (30,000*25%) $7,500 (30,000*25%) = $15,000 After marriage $20,000 $20,000 (80,000*25 %) Marriage tax for some Allow additional $20,000 exclusion $15,000 (60,000*25%) $15,000 (60,000*25%) Marriage subsidy for some In current U.S. tax code, couples with similar incomes are likely to pay a marriage tax couples with very different incomes are likely to receive a marriage subsidy Many have advocated reforming the tax system to be neutral with respect to marital status slide 40 slide 41 Marriage Taxes and Subsidies Ideally, a tax system would have these properties: Two married couples with the same total income pay the same tax. Marital status does not affect a couple s tax bill. A person/family with no income pays no taxes. High-income taxpayers pay a higher fraction of their incomes than low-income taxpayers. However, designing a tax system with all four of these properties is mathematically impossible. Tax Incidence and Tax Equity Recall: The person who bears the burden is not always the person who gets the tax bill. Example: A tax on fur coats May appear to be vertically equitable But furs are a luxury, with very elastic demand The tax shifts demand away from furs, hurting the people who produce furs (who probably are not rich) Lesson: When evaluating tax equity, must take tax incidence into account. slide 42 slide 43
Who Pays the Corporate Income Tax? When the govt levies a tax on a corporation, the corporation is more like a tax collector than a taxpayer. The burden of the tax ultimately falls on people. Suppose govt levies a tax on car companies owners receive less profit, may respond over time by shifting their wealth out of the car industry the supply of cars falls, car prices rise, car buyers are worse off demand for auto workers falls, wages fall, workers are worse off slide 44 Flat Taxes Flat tax: a tax system under which the marginal tax rate is the same for all taxpayers Typically, income above a certain threshold is taxed at a constant rate. The higher the threshold, the more progressive the tax Radically reduces administrative burden Not popular with people who benefit from the complexity of the current system (accountants, lobbyists) people who can t imagine life without their favorite deduction/loophole Used in some central/eastern European countries slide 45 The Case Against Taxing Capital Income Taxes on saving can be found in various forms including capital gains taxes and inheritance taxes. Problem of multiple taxation double taxation on corporate income tax on earnings and then tax on dividends If future income is expected capital gain tax, tax on earnings, dividend tax, High tax on labor Young vs. old slide 46 CONCLUSION: The Trade-Off Between Efficiency and Equity The goals of efficiency and equity often conflict: E.g., lump-sum tax is the least equitable but most efficient tax. Political leaders differ in their views on this tradeoff. Economics can help us better understand the tradeoff can help us avoid policies that sacrifice efficiency without any increase in equity slide 47